Monthly Archives: July 2015

The recent severe volatility in China’s share markets has raised questions among many investors about the causes of the fall and about the wider implications for the global economy and markets generally.

The Shanghai Composite index, the mainland stock market barometer and one dominated overwhelmingly by retail investors, more than doubled in the year from mid-2014, only to lose more than 30% of its value in a month.

The volatility was much less in Hong Kong, where foreign investors tend to get their exposure to China. The Hang Seng index fell about 17% from April’s seven-year high, though it had a more modest run-up in the prior year of about 25%.

Nevertheless, the speed and scale of the fall on the Chinese mainland markets unsettled global markets, fuelling selling in equities, industrial commodities, and allied currencies like the Australian dollar and buoying perceived safe havens such as US Treasuries and the Japanese yen.

The decline in Chinese stocks triggered repeated interventions by China’s government, which has been seeking to transition the economy from a long-lasting export-led boom toward more sustainable growth based on domestic demand.

Investors naturally are concerned about what the volatility in the Chinese market means for their own investments and what it might signify for the global economy, particularly given the rapid growth of China in the past 20 years.

SHARE MARKET VS ECONOMY

Measured in terms of purchasing power parity (which takes into account the relative cost of local goods), the Chinese economy is now the biggest in the world, ranking ahead of the USA, India, Japan, Germany and Russia.1

Yet, China’s share market is still relatively small in global terms. It makes up just 2.6% of the MSCI All Country World Index, which takes into account the proportion of a company’s shares that are available to be traded by the public.

The Chinese market is also not a large part of the local economy. According to Bloomberg, it is capitalised at less than 60% of the country’s GDP. By comparison, the US equity market represents more than 100% of the US economy.

China is classified by index providers as an emerging market. These are markets that fall short of the definition of developed markets on a number of measures such as economic development, size, liquidity and property rights.

China’s stock market is still relatively young. The two major national exchanges, in Shanghai and the other in the southern city of Shenzhen, were established only in 1990 and have grown rapidly since then as China has industrialised.

With foreign participation in mainland Chinese markets still heavily restricted, many foreign investors have sought exposure to China through Hong Kong or through China shares listed on the New York Stock Exchange.

As a consequence, domestic investors account for about 90% of the activity on the Chinese mainland market. And even then, the participation is relatively narrow. According to a China household finance survey, only 37 million or 8.8% of Chinese families held shares as of June 2015.2 As a comparison, just over half of all Americans own stocks, according to Gallup. In Australia, the proportion is 36%.

While the Chinese stock market is about 30% off its June highs, it nevertheless is still about 80% higher than it was a year ago. As such, much of the pain of the recent falls will have been felt by people who have entered the market in the past year.

A final point of perspective is that while the Chinese economy has been slowing, it nevertheless is still expanding at around 7% per annum, which is more than twice the rate of most developed economies.

The IMF in April projected growth would slow to 6.8% this year and to 6.3% in 2016. Still, it expects structural reforms and lower oil and commodity prices to expand consumer-oriented activities, partly buffering the slowdown.3

While such forecasts are subject to change, markets have priced in the risk of a further slowdown to what was previously expected, as seen in the renewed fall in the prices of commodities like copper and iron ore, which recently hit six-year lows.

DRIVERS OF THE BOOM

The Chinese share market boom of the past year cannot be attributed to a single factor, but certainly two major influences have been the Chinese government’s promotion of share ownership and investors’ increased use of leverage.

The government has been seeking to achieve more sustainable, balanced and stable economic growth after nearly four decades of China notching up heady annual growth rates averaging 10% on the back of an official investment boom.

But the transition to a shareholding economy has created its own strains. The outstanding balance of margin loans on the Shanghai and Shenzhen markets had grown to 4.4% of market capitalisation by early July, according to Bloomberg.4

Under a margin loan, investors borrow to invest in shares or other securities. While this can potentially increase their return, it also exposes them to the potential of bigger losses in the event of a market downturn.

When prices fall below a level set by the lender as part of the original agreement, the investor is called to deposit more money or to sell stock to repay the loan. These margin call liquidations can amplify falling markets.

Chinese regulators, mindful of the potential fallout from the stock market drop, have instituted a number of measures to curb the losses and cushion the impact on the real economy.

These have included a reduction in official interest rates, a suspension of initial public offerings and enlisting brokerages to buy stocks backed by cash from the central bank. In the latest move, regulators banned holders of more than 5% of a company’s stock from selling for six months.

The government also has begun an investigation into short selling, which involves selling borrowed stock to take advantage of falling prices. In the meantime, about half of the companies listed on the two major mainland exchanges were granted applications for their shares to be suspended.

While such interventionist measures may seem alien to people in developed market economies, they need to be seen in the context of China’s status as an emerging market where governments typically play a more active role in the economy.

Whether the intervention works in the long term remains to be seen. But the important point is that this is a relatively immature market dominated by domestic investors and prone to official intervention.

SUMMARY

The re-emergence of China as a major force in the global economy has been one of the most significant drivers of markets in the past decade and a half.

China’s rapid industrialisation as the population urbanised drove strong demand for commodities and other materials. Investment and property boomed as credit expanded and as people took advantage of gradual liberalisation.

Now, China is entering a new phase of modernisation. The government and regulators are seeking to rebalance growth and bring to maturity the country’s still relatively undeveloped capital markets.

Nevertheless, China remains an emerging market with all the additional risks that this status entails. Navigating these markets can be complex. There can be particular challenges around regulation and restrictions on foreign investment.

We have seen those risks appearing in recent weeks as about a third of the sharp rise in the Chinese mainland market over the previous year was unwound in a matter of weeks, prompting intense government intervention.

Markets globally are weighing the wider implications, if any, of this correction. We have seen concurrent weakness in other equity markets and falls in commodity prices and related currencies.

Yet it is important to understand that the stock market is not the economy. China’s market is only about 2.6% of global market cap and its volatile mainland exchanges are for the most part out of bounds for foreign investors anyway.

For individual investors, the best course in this climate, as always, is to maintain diversification and discipline and to remember that markets accommodate new information instantaneously.

The world’s markets and media financial pages have been consumed by a single issue in recent weeks—the stand-off between debt-laden Greece and its international lenders over the conditions of any further bailout.

For investors everywhere, both of the large institutional kind and individual participants, the story has been fast-paced and difficult to keep up with. More importantly, the speculation about possible outcomes has been intense.

Of course, no-one knows the eventual outcome or whether there will even be a definitive conclusion. After all, this is a story that has been percolating now for six years, since Greece’s credit rating was downgraded by three leading agencies amid fears the government would default on its debt.

Since then, the Greek situation has faded in and out of public attention as rescue packages came and went and as widespread social and political unrest gripped a nation known as the birthplace of democracy.

But there are a few points to keep in mind. Despite the blanket media coverage of Greece, this is a tiny economy, ranking 51st in the world by GDP in purchasing power parity terms (which takes into account the relative cost of local goods).

On this measure, Greece is a smaller economy than Qatar, Peru or Kazakhstan, none of which currently feature prominently in world news pages. Its economy is about half the size of Ohio in the USA or New South Wales in Australia and about a tenth of the size of the UK. Even within Europe, it is tiny, representing only about 2% of the GDP of the 19-nation Euro Zone.

As a proportion of global share markets, Greece is also a minnow. As of early July 2015, it represented about 0.32% of the MSCI Emerging Markets index and just 0.03% of the MSCI All Country World Index.

And while its total debt is large in nominal terms and relative to its GDP at about 180%, this still represents only about a quarter of 1% of world debt markets.

Of course, what worries investors is not so much Greece itself but the wider ramifications of the debt crisis for its European bank lenders, for the future of the single European currency and for the global financial system.

Yet, many of these concerns are already reflected in market prices, such as in Greek government bonds, the spreads of peripheral Euro Zone bonds, regional equity markets and the single European currency itself.

While no-one knows what will happen next, we can look at measures of market volatility as a rough guide to collective expectations. A commonly cited measure is the Chicago Board Options Exchange’s volatility index, sometimes known as the ‘fear’ index. This has recently spiked to around 18 from 12 in mid-June. But keep in mind the index was up around 80 during the peak of the financial crisis in 2008.

Of course, the human misery and dislocation suffered by the Greek people through this crisis should not be downplayed, neither should the financial risks. But from an investment perspective, there is still little individual investors can do beyond the usual prescription.

That prescription is to remain disciplined and broadly diversified across countries and asset classes and to be mindful that markets accommodate new information instantaneously. So the risk in changing one’s portfolio in response to fast-breaking news is that you end up acting on events that are already built into security prices.

In summary, the events in Greece are clearly worrisome, but Greece is a very small economy and a tiny proportion of the global markets. Events are moving quickly and prices are adjusting as news breaks and investor expectations adjust.

For the individual investor, the best approach remains diversifying across many countries and asset classes, remaining focused on your own goals and, most of all, listening to your chosen advisor, who understands your situation best.

The first Conservative Budget since 1996

We’ve been waiting for this Budget with bated breath since the Conservatives won the election in May – and the Chancellor delivered a lot in his “big Budget” of Summer 2015. In many ways, Mr Osborne’s announcements this time around are more important than in March, as this Budget sets out many of the measures the Conservatives have wanted to put in place for some time.

How is this Budget going to affect you? One of the most talked about features has been the plan to cut the welfare bill by £12bn, as Mr Osborne aims to be “bold in building the aspirations of working people”. There will be major changes to the system of tax credits, with only those lowest-income families being able to claim tax credits. This will be combined with changes to entitlement to Universal Credit.

Property also featured heavily, with some important changes for landlords:

Tax relief on mortgage interest payments on residential property will be restricted to the basic rate of tax, a change that will be phased in over four years from April 2017.

Private landlords will also see the 10% wear and tear allowance replaced by deductions for the actual cost of replacing furnishings.

There will be an extra inheritance tax nil rate band for main residences passed on death to descendants, starting at £100,000 in 2017-18 and rising to £175,000 by 2020/21.

As usual, we are on hand to help you if you would like to discuss any of the issues raised in the Summer Budget in further detail. To get in touch, please telephone 0115 9075100 and ask to speak to your Financial Adviser or email us.

Please note: The content of our Budget Summary is intended as a guide only and should not be relied upon. Therefore no responsibility for loss occasioned by any person acting or refraining from action as a result of the material contained in this briefing can be accepted by the authors or the firm. Russell Ulyatt Financial Services Ltd does not accept responsibility for the content.

Pension automatic enrolment is getting closer to home

The roll out of automatic enrolment of employees into pension schemes started back in October 2012 with the largest employers. The logic was that these big organisations would have the necessary resources to start the process quickly and efficiently. Since those early days, the size of employers required to introduce automatic enrolment has been shrinking. As of this month, the threshold fell to fewer than 30 employees.

This is the minimum threshold and embraces nearly 800,000 small and micro employers. In this group, the precise timing (“staging date”) for when automatic enrolment must be offered is driven by PAYE coding letters, which can have unusual effects. For example, two employers working from the same premises might have staging dates two years apart.

The first sub-30 group (with the last two letters of PAYE reference numbers 92, A1-A9, B1 – B9, AA-AZ, BA-BW, M1-M9, MA-MZ, Z1-Z9, ZA-ZZ, 0A-Z, 1A-1Z or 2A-2Z) have now reached their staging date of 1 June 2015. That has prompted some press coverage about the employment of nannies. Parents who employ nannies directly fall within the automatic enrolment rules, even if the recruitment of the nanny was originally via an agency. The initial pension cost will be modest – generally 1% of earnings above £5,824 – but the rate will rise to 2% in October 2017 and 3% a year later. For a nanny in London that could mean employer pension contributions of more than £1,000 a year from autumn 2018.

The pensioning of Mary Poppins is a reminder of the way auto-enrolment is working its way through to all employers. If any of your clients are an employer – of any sort – make sure they know their staging date and understand their responsibilities. Failure to do so could lead to escalating fines from the Pensions Regulator

The value of investments can go down as well as up and they may not get back the full amount invested. The value of tax reliefs depends on individual circumstances. Tax laws can change.

David served as a Director between November 1995 and January 2006 following which time he moved to a part-time role with responsibility for our Training and Competence and investment research.

David has been a loyal and supportive colleague during his time at Russell Ulyatt and we will all miss him. We wish David all the very best for a long, happy and healthy retirement.

David had the following farewell message ..

Looking back, twenty five years seems a very long time but it has certainly flown by in a flash to me. It’s been so good to see how our company has grown and developed in that time, whilst maintaining the same professional standards.

I’d like to send my best wishes for the future to all my colleagues and clients.

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Please note: All articles correct at time of going to publication. Older (archived) posts may no longer be correct or currently valid.